Background

Purpose: This case is an opportunity to do cash flow analysis and the adjustment of the discount rate to accommodate project risk and analyze the associated impact on the decision-making process. This case is closely aligned with Chapter 12 and Chapter 13

Conestoga International Inc.

Imagine that you are the new CFO of Conestoga International Inc. In your first week on the job, you discover that Conestoga International Inc. has been using a single discount rate in the evaluation of all projects, which is currently set at 10%.

You began to wonder if the risker projects should have a higher discount rate than more conservative ones. Afterall, some projects are certainly riskier than others, and there must be a way to incorporate risk level in an investment decision.

You remember from your finance background that there is a way to account for risk in the capital budgeting process, so you established different risk categories and an associated discount rate for each category (See Figure 1).

Figure 1 - Risk Adjusted Discount Rates

Risk Category Discount Rate

Low risk (equipment repair) 5%

Low to moderate (new equipment)7%

Moderate risk (expansion of product line)10%

Moderate to high risk (new product in domestic market)13%

High Risk (produce an established produce in a foreign market)17%

Very High Risk (Produce a new product in a foreign market)20%

Currently, Conestoga International Inc. is deciding on whether to pursue two projects. Both projects require a $200,000 investment in equipment. Additional details about each project is below:.

• Project A: Introduce New Product in Domestic Market

Discount rate 13% based on Figure 1 __Working capital requirements of $20,000 to operationally support the project

• Project B: Introduction of a well established in foreign market

• 17% discount rate based on Figure 1
• Working capital requirements of $15,000 to operationally support the project

The cash flows from Project A and Project B are outlined in Figure 2 Below:

Figure 2

Year

1

2

3

4

5

Project A

$45,000

60,000

90,000

125,000

150,000

Project B

55,000

65,000

95 000

135,000

165,000

Requirements

1. Calculate the payback period for both projects. Which project would you select using payback period as the only methodology of project selection? Can the payback period be an indicator of risk? If so, how? If not, why not?
2. Compute the Present value of the two projects based on a discount rate of 10%. Which of the two should Conestoga International Inc. select? Why?
3. Compute the present value of the two projects based on the risk-adjusted discount rate. Which project should Conestoga International select using this approach? Why?
4. Do you think a 5-year time horizon is appropriate for evaluating Project A or Project B? Why or why not?
5. Figure 1 indicates that foreign markets should carry a high discount rate because they are riskier. However, you remember that diversification can reduce risk. Thus, you begin to wonder if you have miscategorized the rankings in Figure 1. In a single paragraph, comment on whether the original rankings in Figure 1 are correct, or if you should redo the risk-adjusted discount rate analysis with revised rankings and why (Note: Do not recalculate the present value in part 3).

Requirements:

1. Payback period 2. PV at 10%

3. PV at risk-adjusted

1. Time horizon assessment
2. Risk rankings comment Professionalism